McKinsey Says Investment Banks Should Merge FICC, Stocks

Investment banks have exposed themselves to inefficiencies and duplication by organizing by asset class, separating traders who buy and sell stocks from those who deal in commodities or currencies, according to a report by McKinsey & Co. Photographer: Andrew Harrer/Bloomberg

Nov. 20 (Bloomberg) -- The world’s largest investment banks
should enact changes including “ruthless prioritization” of
clients and combining fixed-income and equity trading to avoid a
sharp decline in profitability, according to McKinsey & Co.

The companies should cut the number of products they offer
and push many clients to electronic platforms, New York-based
McKinsey said in an annual review of the investment banking and
trading industry released today. The firms must also understand
which clients are most profitable and restrict use of balance
sheet to those customers, according to the report.

McKinsey offered ideas to help improve profitability as it
said the return on equity was 8 percent last year at the 13
largest investment banks and may drop to 4 percent by 2019
without remedies. Companies have largely dealt with obstacles as
they arise instead of implementing a more comprehensive
strategy, the consulting firm said in its report.

“The extent of the challenges facing the current business
model suggest there is a serious question over its viability,”
the consultants wrote. “The mathematics of the old world view
no longer add up.”

The 13 largest firms trailed performance of the broader
investment-banking industry, which produced a 10 percent return
on equity last year, according to the report. The largest firms
could see ROE drop by half amid new leverage restrictions,
additional rules on trading and derivatives, and revenue growth
that will probably be just 1 percent annually over the next few
years, according to the report. ROE is a measure of how well a
company uses reinvested earnings to generate additional profit.

‘Execution Factory’

McKinsey said the average large investment bank needs to
cut costs by an additional 25 percent, and reduce risk-weighted
assets by $60 billion while increasing revenue by $1 billion to
reach a 12 percent return on equity. The way banks currently
operate, as many as 20 percent of clients are unprofitable,
Kevin Buehler, a director at the consulting firm, said in an
interview yesterday.

“Banks can no longer afford to provide all products to all
clients in all geographies with a full-service approach,”
Buehler said.

Investment banks have exposed themselves to inefficiencies
and duplication by organizing by asset class, separating traders
who buy and sell stocks from those who deal in commodities or
currencies, according to the report.

Instead, firms should organize into an “execution
factory” that handles most flow trading of standardized
products, largely through electronic platforms, according to the
report. That includes interest-rate swaps, which will more
closely resemble equities as they are traded on swap-execution
facilities, Buehler said.

Reduce Headcount

“The asset class by asset class mindset is quite deeply
embedded in most organizations,” Buehler said. “You still need
sales professionals who understand what their clients’ needs are
in that asset class, but the bundling across asset classes may
be quite different.”

Banks should also have a separate division that designs and
structures unique hedges and other products for clients, and
another group that allocates all funding and customer financing,
McKinsey said.

The portion of global investment-banking and trading
revenue that comes from Asia, excluding Japan, will surpass that
of North America by 2017, McKinsey said. In that year, Europe,
Middle East and Africa will contribute 33 percent, down from 39
percent in 2012, while Latin America will climb to 4 percent
from 3 percent last year.

Firms must also continue to reduce headcount and try to
determine the true profit a trader generates beyond an average
employee in his or her spot in order to most efficiently
distribute compensation, according to the report.

“Most banks are doing a much better job than in the past
in aligning compensation with absolute performance levels,”
according to the report. “The next stage is to better identify
value created by incremental profits generated, rather than the
‘value of the seat’ of the underlying franchise, with pay-out
ratios recalibrated accordingly.”